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182 Part Two Riskwhich has a relatively high standard deviation, is a leading member of the low-beta club in the
right-hand column of Table 7.5. It seems that while Newmont is a risky investment if held on
its own, it does not contribute to the risk of a diversified portfolio.
Just as we can measure how the returns of a U.S. stock are affected by fluctuations in the
U.S. market, so we can measure how stocks in other countries are affected by movements in
their markets. Table 7.6 shows the betas for the sample of stocks from other countries. As in
the case of our U.S. sample, the highest betas include an auto company.Why Security Betas Determine Portfolio Risk
Let us review the two crucial points about security risk and portfolio risk:
∙ Market risk accounts for most of the risk of a well-diversified portfolio.
∙ The beta of an individual security measures its sensitivity to market movements.
It is easy to see where we are headed: In a portfolio context, a security’s risk is measured by
beta. Perhaps we could just jump to that conclusion, but we would rather explain it. Here is an
intuitive explanation. We provide a more technical one in footnote 33.Where’s Bedrock? Look again at Figure 7.11, which shows how the standard deviation of
portfolio return depends on the number of securities in the portfolio. With more securities,
and therefore better diversification, portfolio risk declines until all specific risk is eliminated
and only the bedrock of market risk remains.
Where’s bedrock? It depends on the average beta of the securities selected.
Suppose we constructed a portfolio containing a large number of stocks—500, say—drawn
randomly from the whole market. What would we get? The market itself, or a portfolio very
close to it. The portfolio beta would be 1.0, and the correlation with the market would be 1.0.
If the standard deviation of the market were 20% (roughly its average for 1900–2014), then the
portfolio standard deviation would also be 20%. This is shown by the green line in Figure 7.15.
But suppose we constructed the portfolio from a large group of stocks with an average beta
of 1.5. Again we would end up with a 500-stock portfolio with virtually no specific risk—a
portfolio that moves almost in lockstep with the market. However, this portfolio’s standard
deviation would be 30%, 1.5 times that of the market.^32 A well-diversified portfolio with a
beta of 1.5 will amplify every market move by 50% and end up with 150% of the market’s
risk. The upper red line in Figure 7.15 shows this case.
Of course, we could repeat the same experiment with stocks with a beta of .5 and end
up with a well-diversified portfolio half as risky as the market. You can see this also in
Figure 7.15.(^32) A 500-stock portfolio with β = 1.5 would still have some specific risk because it would be unduly concentrated in high-beta indus-
tries. Its actual standard deviation would be a bit higher than 30%. If that worries you, relax; we will show you in Chapter 8 how you
can construct a fully diversified portfolio with a beta of 1.5 by borrowing and investing in the market portfolio.
Stock Beta (β) Stock Beta (β)
BHP Billiton (Australia) 1.61 LVMH (France) 0.96
BP (U.K.) 1.25 Nestlé (Switzerland) 0.66
Siemens (Germany) 0.91 Sony (Japan) 1.42
Samsung (Korea) 0.96 Toronto Dominion Bank (Canada) 0.67
Industrial Bank (China) 1.39 Tata Motors (India) 1.52
❱ TABLE 7.6
Betas for selected
foreign stocks,
December 2009–
December 2011 (beta
is measured relative
to the stock’s home
market).